Investing Theory

The Surprising Irrelevance of Profits in Today’s World

October 12, 2023

Everyone who runs a company knows very well that showing the highest possible profits is the last thing desired by the company’s owner, because… profits are taxed. The bigger the profit, even on paper, the bigger the tax to be paid.

If the owner has a choice between giving a part of their earnings to the IRS or investing that money in the company’s development, upgrading equipment, purchasing services or products that will be used in the future, it is obvious what they will choose.

This is confirmed by the observed annual shopping frenzy in December, when companies try to generate as many costs as possible at the end of the fiscal year to minimize their tax burden. Stock market companies are no different in this respect.

However, taxes are not the only factor that deters entrepreneurs from showing the highest possible profits.

Reinvesting Pays off Big Time

CEOs of growth companies – which have been operating in the market for just a few, sometimes several years, and are still in the process of creating economies of scale – openly admit that showing profits and paying dividends are not in the interest of the company nor their shareholders, because at this stage, all revenues should be immediately reinvested in the company’s development and expansion.

For companies striving for dominance in their industry, conquering new markets, and dynamically increasing the scale of their operations, every cent dedicated to this purpose matters.

On the other hand, steadily growing profits are very well seen in mature companies that have long passed their growth phase.

We will look differently at the lack of profit in a company like Uber, which has only recently entered the market, and differently at the potential lack of profit in a company like Coca-Cola.

The matter of profit visualization.

In the first case, revenue growth will be of the utmost importance, as it shows that the company is gaining market share, new customers, and building economies of scale. In the second case, there can hardly be any talk of economies of scale, as the company is already present everywhere.

Therefore, the most important role now is not the dynamic growth of revenues, but generating profits with them and sharing the spoils with their shareholders. The spoils can, of course, be a buyback, i.e., the repurchase of own shares, and/or dividend payment. Two different companies, two different business models, two different stages of development, and two completely different interpretations of the lack of profits shown in financial statements.

The Problem with Money on Paper

Another problem with profits is that they are shown… on paper. Generally accepted accounting principles require sales to be booked even when the money from them has not yet actually reached the company’s account.

Let’s imagine that a small manufacturing company packed all its goods on a ship in December and sent them to a customer along with an invoice, on which the payment deadline was 180 days. Let’s use our imagination even more and say that the ship sank. The company issued sales invoices, shipping occurred, i.e., the goods were sent, so the sale was recorded.

However, the customer will never pay for goods they did not receive, so the manufacturing company will record a profit, but there will be no cash inflow to its bank account behind that profit.

This is an extreme situation and probably would be covered by insurance; but what if the ship arrived, and in the meantime the recipient declared bankruptcy and ultimately did not pay for the goods? It rarely happens, but it does happen. There is profit, but no money.

The next aspect to be aware of is that the amount of profit shown in financial statements can be very susceptible to manipulation by accountants. It is not so much about manipulation in bad faith, but rather – to put it mildly – shaping profits subject to creative accounting. Here we reclassify something, there we defer something, here we change the title – and suddenly in the fiscal year, 50 million in profit turns into 30 million or 70 million, depending on the goal the accountant had in mind.

Moreover, the level of reported profit often depends on the accounting principles adopted. The same activity (cost or revenue) can be accounted for differently depending on whether the company follows US GAAP, non-GAAP, European IFRS, or Chinese-lack-of-rules.

Another interpretative problem is one-time events, which can cause spectacular profits or losses, but non-recurring. If a company sold a third of its factory and half of its production lines, generating a large one-time profit, would it really be good news for future shareholders? After all, this profit will not be repeated, and lower production capacity will result in lower sales in the future.

The Accounting Issue

An additional complication is the chosen method of estimating depreciation and amortization, which reduces the final net profit. To some extent, it is determined by accounting rules, but ultimately the company’s accounting department or CFO has some discretion in estimating equipment wear and tear.

One solution to this problem is to use EBITDA, or earnings before interest, taxes, depreciation, and amortization, or NOPAT, which is operating income after paying taxes. Nevertheless, the multitude of profit calculation variants only shows that each of these parameters is largely subjective, prone to manipulation, and difficult to interpret unambiguously.

Profits are, of course, important, but they are not a sine qua non condition for a company to be included in an investment portfolio. Revenues are the most important. In case of high revenues, if necessary, accountants can always conjure up some profits, even if only visible on paper. The problem is that such profits cannot be used to repay debt or pay wages to employees.

Many companies in history have gone bankrupt even though their financial statements showed profits. What’s the use of a company having significant profits on paper if the actual cash balance (or in bank accounts) does not correspond to these profits?

Therefore, profits should be considered only in the context of cash flowing into the company. The most important thing is to answer the question of whether the profits shown on paper have any coverage in the actual cash entering the company’s cash register. And if so, where does this cash come from.

Still curious for more? Read more about the importance of cash here: Exploring the Timeless Power of Hard Currency

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